Container ships are pictured docked at the Colombo South Harbor, funded by China, in Colombo, Sri Lanka, July 26, 2016.

Image Credit: REUTERS/Dinuka Liyanawatte

Sri Lanka's Debt and China’s Money

Faced with difficult choices, Sri Lanka has to hope China’s Belt and Road can bring prosperity.

By Umesh Moramudali for The Diplomat

August 16, 2017

Recently, the Sri Lankan government signed a concessionary agreement for a joint venture between the China Merchants Port Holdings Company Limited (CMPort), China’s state-owned port company and the Hambantota port, which is the second largest port in Sri Lanka. According to the agreement, 70 percent of the Hambantota port will be owned by the Chinese company while the Sri Lanka Ports Authority (SLPA) owns the remaining shares.

The port deal, which has led to many controversies, was not the most favorable choice for the government but it was perhaps the only choice.

By now, Sri Lanka’s situation in terms of managing the external debt is quite distressing. As Sri Lanka was upgraded to a middle income country, most of its concessionary debt was cut off and this scenario forced the government to obtain commercial debt. In addition to the Export-Import Bank of China (China Exim Bank) loans taken at a higher interest, funds were raised through sovereign bonds at commercial interest rates.

As a result, over the last decade the composition of the country’s external debt has changed dramatically, with a shift toward costlier, non-concessional debt from previously available concessionary debt. Accordingly, in 2006, only 6 percent of external debt was commercial debt, but by 2012 it exceeded 50 percent of the external debt. This has resulted in a drastic surge in interest paid on external debt, leaving the country rather vulnerable to an economic crisis.

Back in 2006, Sri Lanka’s external debt stock was only $10.6 billion. Within the last decade, it has increased by nearly 140 percent.

By the end of 2016, Sri Lanka’s external debt stock soared to $25.3 billion, which amounts to 34 percent of the country’s gross domestic product. Out of this massive debt stock, about 13 percent — which amounts to $3.3 billion — is owed to China; most of the debt to China was obtained over the last decade.

The former Sri Lankan regime led by then-President Mahinda Rajapaksa is in part responsible for China’s growing ownership of Sri Lankan debt. Rajapaksa was not a popular leader amongst Western countries, but was a close ally of China, and was not hesitant to borrow from Beijing and invest in infrastructure projects. As the saying goes, “When money comes your way, do not ask questions.”

Rajapaksa didn’t; the questions came later.

The Hambantota port, a major portion of which was leased to China for 99 years, was one such infrastructure project financed by China and constructed during the Rajapaksa regime. It was not originally meant to be leased to Beijing, although it was constructed using debt obtained from China. However, as time went on, Sri Lanka found it difficult to pay back the loans taken from China’s ExIm Bank at the commercial interest rate for the port’s construction. There was not much return on investment from the port, similar to the fate of the Mattala airport located nearby. The low return on the projects combined with the high interest rate to be paid to the Chinese has ensnared Sri Lanka in a debt trap. The government had no option but to share the asset with the Chinese.

Most importantly, these Chinese debts were invested in developing strategic locations of the country, giving some control of those areas to China. Beijing’s strategy — establish power in the South Asian region through economic diplomacy — was closely observed by India. New Delhi’s strategic concerns had placed the Sri Lankan government between a rock and a hard place.

China’s economic dominance in Sri Lanka was not in terms of debt, but also investments. In 2005, the annual foreign direct investment (FDI) inflows from China were just under $1 million, but 2014 that figure had soared to over $400 million. These massive FDI inflows went into the controversial Colombo Port City project, later termed as the Colombo International Financial Center. The center raised concerns about Sri Lanka’s sovereignty since the filled-in land in Colombo would be leased out to the Chinese for 99 years with the expectation of a separate law being applied to the filled-in land. During the last decade, $1.1 billion in FDI was received from China and during the same period only $400 million in FDI was received from the United States.

The Belt and Road Initiative and the Way Forward

Given the poor performance of Sri Lanka’s external sector and slowed growth in the West, Sri Lanka, in fact, had no option but to reach out to China for money. To put it simply, China is where the money is.

As Sri Lanka fails to increase its export revenue in light of the soaring external debt servicing payments, the country has to look to other options to raise funds, which seem to come through debt and investments from China. Yet, it remains an open question whether Chinese money has made the situation go from bad to worse due to the high interest on loans and the possible geopolitical consequences of Chinese influence.

It is with that backdrop that China’s Belt and Road Initiative (BRI) presents offers to the countries across the region. Given the economic crisis that the country has faced, Sri Lanka is not in a position to refuse these offers. Sri Lanka does not have many options left while China has many options to pick from. China has already invested heavily on the Gwadar port in Pakistan and is investing heavily in Bangladesh as well. In this context, Sri Lanka will have to take the Chinese offers to rescue itself from a possible economic downturn. Yet again, the concern is how well these Chinese deals are negotiated and on what conditions Chinese debt is obtained. Given India’s approach of staying away from the BRI, the geopolitical implications that Sri Lanka has to face will be inevitable. Yet, if the Chinese bring good economic prospects through the BRI, adverse geopolitical consequences would not be a bad compromise given that many countries in the region are part of China’s initiative despite India’s objections.

However, diplomacy, like debt, can be flammable if not handled with care. Thus far, debt obtained without farsightedness has put Sri Lanka smack in the middle of the devil and the deep blue sea — meaning Sri Lanka is faced with difficult choices and has only risky options to chose from. It will be a challenging task for Sri Lanka to balance and battle through, making compromises where needed and striving to ensure the national interest where necessary.

Umesh Moramudali is an economic columnist and holds a BA in economics. He has conducted extensive research on international trade in Sri Lanka.